Commodities Exchange-Traded Funds: How They Work

There are three ways that exchange-traded funds gain exposure to commodities: direct physical exposure, commodities-futures-contract-based exposure, and commodity-related equity security exposure. Each has its benefits and drawbacks, and it is important to know how your ETF is structured.

Equity-based funds

Equity-based funds will hold a basket of the equity securities of companies that are involved in the production of a particular commodity. While equity based commodity exposure may serve well as a sector bet, one drawback to equity based exposure to commodities is that business operations can by impacted by a number of factors outside of the price fluctuations of the target commodity. Thus, the exposure provided by these equity based funds is not considered a "pure-play" on the target commodity.

Physical shares ETFs

Physical shares ETFs provide exposure by holding the physical commodity. These funds are usually structured as "grantor's trusts" and will issue baskets of shares to authorized participants (APs) in exchange for the physical commodity. Physically backed shares offer the most direct exposure to price fluctuations of the spot commodity. While the physically backed ETFs provide a convenient and cost effective method of getting direct exposure to the commodity, they tend to deal solely in the precious metals space, where storage costs are low.

Futures-based ETFs

Futures-based ETFs are the most common type of commodity ETF. They allow funds to deliver exposure to a broad basket of commodities without having to actually store the commodity. A futures contract is not a commodity, but a derivative which obligates each party to buy or sell the commodity in a quantity and at a time specified by the contract.